We believe the European Central Bank (ECB) will aim to bring its interest rates into neutral territory reasonably quickly following its decision to raise its policy rate by 75 basis points (bps) at its September meeting. The policy rate hike means the deposit facility rate now stands at 0.75%, halfway to most estimates for where a neutral policy stance will be in the long run (at 1.5%).
At the press conference, ECB President Christine Lagarde said there will be more rate hikes to come, and that the ECB currently doesn’t have a strong view on the end point of the interest rate journey. Lagarde also made clear that quantitative tightening will be on the agenda only at a later stage of the policy normalisation cycle. She added that the ECB is absolutely determined to bring inflation back to target and the Governing Council doesn’t want inflation expectations to de-anchor, and risk any second-round effects taking hold.
The market took note, with interest rates moving higher during the press conference, and the terminal policy rate repricing from around 2.15% to 2.25%.
How restrictive will the ECB be?
More relevant than the precise journey of rate hikes will be the destination. ECB chief economist Philip Lane recently reiterated that cyclical factors may require policy rates to move above or below neutral in order for inflation to stabilise at target.
There remains considerable uncertainty where a neutral policy rate for the euro area might be, but around 1.5% in nominal terms seems reasonable, especially in comparison to other developed market jurisdictions such as the U.K. or U.S. Current market pricing therefore suggests somewhat restrictive territory for the ECB, with a peak policy rate of 2.25% around the middle of next year.
In line with its new meeting-by-meeting approach, the ECB did not provide much guidance regarding the potential destination of interest rates. But President Lagarde indicated that a neutral policy setting might not be appropriate in all conditions, particularly if it is faced with high spot inflation that, as we have said, would threaten to de-anchor medium-term inflation expectations and increase the risk of second-round effects.
Normalizing policy rates, in the context of €4.5 trillion excess liquidity and collateral scarcity, risks impairing the monetary policy transmission. Hence why the market was eagerly awaiting guidance on a number of items, such as bank excess reserve remuneration and the remuneration of government deposits at the central bank. With its decision to remunerate bank excess reserves at the deposit facility rate and temporarily suspend the 0% cap on the remuneration of government deposits, the ECB managed to alleviate concerns about a wave of demand for front-end high quality collateral amid limited supply.
We expect the ECB to continue exploring options to better control money market rates, potentially along the lines of the Fed’s reverse repo facility. Medium-term options include a new secured or unsecured vehicle available to market participants without access to the ECB’s deposit facility, or large-scale issuance of very short-term ECB debt certificates.
The medium-term path of monetary policy
We believe the ECB will be reluctant to materially slow the pace of rate hikes until the peak in inflation is in the rearview mirror. Having started hikes higher than the traditional 25-bps increment, there appears little reason to change that pace significantly while the monetary policy stance remains accommodative.
We believe the ECB will aim to bring its policy rates into neutral territory reasonably quickly, and expect additional 50-bps policy rate hikes in October and December as a result. After that, we expect 25-bps increments next year as the hiking cycle pivots more decisively from policy normalisation to policy tightening.
Please visit our Inflation and Interest Rates page for further insights on these key themes for investors.
Konstantin Veit is a portfolio manager based in London and a regular contributor to the PIMCO blog.